Corporate Control and Credible Commitment

The separation of control and ownership – the ability of a small group effectively to control a company though holding a minority of its cash flow rights – is common throughout the world, but also is commonly decried. The control group, it is thought, will use its position to consume excessive amounts of the firm’s returns, and this injures minority shareholders in two ways: there is less money and the controllers are not maximizing firm value. To the contrary, we argue here that there is an optimal share of the firm that induces the control group to maximize shareholder value while inducing investors to fund the firm’s projects. The concern that controlled companies raise is that it is difficult for the controlling group to commit not to consume more than the optimal share. A firm’s cost of capital is increasing in the controllers’ inability to solve this credibility problem because potential investors will charge the firm for later consuming private benefits. Today, accurate judicial review of controlled transactions under mandatory fiduciary rules helps controllers to commit not to take more than the optimal share. Private contracting and judicial review can be strong complements, however. Therefore, our principal normative recommendation is to open up the contracting space by reducing fiduciary rules to defaults. This reform would be * In December 2011, the authors prepared a report on behalf of an Israeli company for filing with an Israeli Law Reform Commission concerning proposed amendments to the Israel corporate law that would affect the corporate governance duties of companies that exerted control over other companies in which the controlling shareholder held a minority equity stake. Certain of the thoughts we expressed in that Report were a highly inchoate version of the ideas developed below. ** Meyers Professor of Law and Business, Stanford Law School; Stern Professor of Law and Business, Columbia Law School; and European Corporate Governance Institute. Sterling Professor of Law, Yale Law School, and Professor, Yale School of Management. This is a much revised version of an earlier paper “Contracting About Private Benefits of Control” (2013). Al Klevorick and Ivo Welch’s helpful suggestions improved this revision.